Entries to Natural Order are dedicated to promoting an open & free society.

Monthly Archives: May 2015

“Great part of that order which reigns among mankind is not the effect of government. It has its origin in the principles of society & the natural constitution of man. It existed prior to government, & would exist if the formality of government was abolished. The mutual dependence & reciprocal interest which man has upon man, & all the parts of civilised community upon each other, create that great chain of connection which holds it together. The landholder, the farmer, the manufacturer, the merchant, the tradesman, & every occupation, prospers by the aid which each receives from the other, & from the whole. Common interest regulates their concerns, & forms their law; & the laws which common usage ordains, have a greater influence than the laws of government. In fine, society performs for itself almost everything which is ascribed to government.”

Modern central banks were & are justified on the grounds that they provide a means to insure economic stability by supporting “sound” money & “sound” banking practices. However, there is considerable reason to believe that central banks create “moral hazards” that undermine both “sound” money & “sound” banking.

Walter Bagehot specified the role of central banks as lender-of-last-resort in response to a liquidity crisis. According to him, they should lend “freely”, but temporarily, against sound collateral & at penalty rates. It is clear that Bagehot did not think much of the argument in insisting on such stringent limits.

But modern central banks do not take Bagehot’s case to heart. His idea of setting a penalty rate was to provide a motivation for commercial banks to pay off emergency loans once financial markets returned to normal conditions. However, central banks tend to provide liquidity at subsidized rates for periods without imposing strict limits on the duration of the loans.

In all events, the role of lend-of-last-resort seems to be made necessary when central banks hold most of the reserves of the banking system so there are few other sources of liquidity.

Concentrating reserves in one place creates a moral hazard that undermines the presumed benefits of central bank interventions to offset liquidity problems so that the banking system will be less stable. As banks scramble for liquidity after a credit crunch, they will all seek funds from a common pool of reserves that can cause the money supply to contract.

As central bankers offer relaxed collateral requirements and lend at subsidized interest rates, insolvent institutions divert resources from solvent ones. As solvent banks will be unable to lend, credit and overall economic activity will be stifled.

At the same time, deposit insurance that replaced the doctrine of “double liability” previously imposed on bank owner-shareholders undermined sound banking practices.

From the end of the Civil War to the Great Depression, stockholders of nationally-chartered banks had to place more capital if the institution was impaired or insolvent. As such, shareholder-owners of US commercial banks were held responsible both for its safety and soundness.

This “doctrine of double liability” meant that they were responsible for a portion of bank debts after insolvency, an amount up to and including the par value of their stock. Despite being contrary to the “limited liability” notion of conventional corporations, the US Supreme Court, lower federal courts and state courts upheld this arrangement.

Double liability meant that if investors engaged in risky activities for their own advantage would bear the burden if the increased risks led to losses. Since many small banks are closely held while most larger banks tend to be controlled by a bank holding company, shareholders will be more likely to be successful in controlling the risk-taking tendencies of banks.

Supporters of deposit insurance insisted that it provided better arrangements for covering risks of losses, while ignoring “moral hazard” issues arising from it as well as the loss of the beneficial effects of the “doctrine of double liability”.

Most economists oppose government interventions that grant privileges to domestic producers, especially those that create price distortions arising from tariffs or quotas.

Despite this near-consensus, protectionist economic policies are the last domain of scoundrels, usually driven by the venality of the political class that support privilege-seeking trade unionists or industrialists.

Recent events show that these policies are not only economically irrational & counter-productive, they are also often have deadly consequences.

Turkish authorities have been using deadly means in an attempt to curb “smuggling”, an activity that is most often induced by excessive restrictions of access to certain goods or high tax rates on their consumption. A few weeks ago, 25 unaccompanied mules were shot dead by F-16s.

As it is, a more peaceful way to cope with smuggling, especially of harmless goods, is to allow free trade. For their part, Turkish villagers were quoted:

“We do not call it smuggling. “t is trade.”

Meanwhile, it has been reported that customs checks are holding up relief supplies for Nepal quake victims.

What is really at stake is government officials either refusing to relinquish some amount of power they have or their own access to revenue flows.

Protectionism is a cynical & deadly game that has real human costs & sometimes deadly consequences.

Many economists predicted that unconventional monetary theory, especially “quantitative easing” (QE) would lead to a dramatic rise in price levels, so-called price inflation.

A quick perusal of the normal measures of price inflation, e.g., consumer price indexes (CPI), suggest that nothing could be farther from the truth. Indeed, most central bankers are engaging in continuous handwringing over price deflation, going so far as to coin a new term, “slowflation” to depict worryingly-low changes in CPI or GDP price deflators.

It turns out there is more to all this than meets the eye.

Economists worry about the effect of excessively-loose monetary policy on rising price levels because it involves an erosion of purchasing power and a decline the value of saving. As it is, zero-interest rate policy (ZIRP) has been the cause of a massive collapse in the value of deferred consumption.

Central banks forcing of nominal interest rates ever closer to (or exceeding!) zero around the world has had the same corrosive effect on living standards as out-of-control increases in consumer prices. Collapsing yields on financial assets has much the same effect as price inflation since lower earnings on a stock of saving requires more capital or a longer time to accumulate earnings to maintain a given living standard.

Consider that you have $100 in capital assets earning 10% such that this yield allows you to consume goods worth $10 at current prices. Even if price levels remain unchanged, an impossibility in a fiat-money world, yields of .01% would require 100 years of accumulated earnings to buy $10 worth of goods. Alternatively, you would need to have $10,000 in capital.

Clearly, this is no different in effect than if there had been (hyper) inflation.

Looking back over the past 40 years, interest rates have been on a downward trend that has continuously undermined the value of saving, especially in the hands of the middle class.

Ending “financial repression” arising from ZIRP & associated central bank policies may be the most important first step to bring an end to the slow-growth recovery that has been underway since 2009.